This Is What Happens In Greece

In spite of all the rhetoric, Greece will make the May payments. Whoever is in charge will get calls from Merkel, Lagarde, and Draghi warning them of the global carnage that would ensue if they miss those payments. I think in this case they are right. Missing €450 million of private sector debt and €3 billion owned by the ECB would likely cause a global stock market route of 5%. At the same time, I suspect that Hollande and maybe even Obama would call with words of encouragement for Greece, and pledges to support them in getting better terms, but that they need time, and paying the May debt is necessary for everyone to have time to organise.

So the May debt gets paid. In return, Greece is allowed to drop some provision about immediate job cuts. Austerity is out of favour anyways, and it would let the new government safe enough face, on a subject that has become controversial across Europe.

I think markets react with a sigh of relief if that occurs, but then the real fun begins.

The first thing that needs to be addressed is the bank recapitalization. That needs to be done quickly, so that the economy can function better, but it doesn’t need to be done according to the original plan. Shareholders need to be wiped out. The banks need to be nationalized, and shareholders and preferred creditors just lose everything. Depositors need to be fully protected. I would have bondholders take losses, but since at this point the only bond lenders are probably all domestic, that causes more problems than it solves, though extending the debt and reducing the coupon would be a good step.

This should reduce the amount of money needed from the Troika and more importantly gives all of the upside to the Greek people. A successful nationalization program should require the least amount of money and give the people the most control. If that occurs, expect big selling pressure on the weakest Spanish and Italian banks as the “monkey see”, “monkey do” effect takes hold.

The other key element of the program will be serious negotiations with the ECB. For all of their supportive talk, quite frankly the ECB has acted like a jerk in the restructuring of Greece. After the May payment, the ECB will still own about €50 billion of debt, with the bulk of it maturing in the next 5 years. Let’s assume that it has an average cost of 85% of par (just a guess, but doesn’t seem to far off). So the ECB’s cost is €42.5 billion. The ECB will have been paid back at least €10 billion so far on bonds they bought that matured. Assuming an average price of 90 on those (they were shorter dated), then the ECB has already booked a profit of €1 billion. On the €60 billion that the ECB held, let’s assume the average coupon 4.5% (possibly a bit low) and that they held for about 18 months on average. That is about €4 billion of interest that the ECB would have received so far on their Greek bond purchases. So the “breakeven” for the ECB on their existing bonds only about €37.5 (my guess). The ECB should agree to swap their remaining bonds for about €37.5 billion of the new PSI bonds. Seriously, it’s not like the ECB is mark to market. They don’t need a profit and if anyone can live on 2% interest it is an entity that prints money. This quickly wipes out €12.5 billion of debt for Greece (my guess is the real number using my methodology would be greater). It also reduces annual interest cost from roughly 4.5% on €50 billion (€2.25 billion) to 2% on €37.5 billion (€0.75 billion). Annual savings to the country of €1.5 billion – I even know some hedge fund managers who would get out of bed for that sort of money. It will also push debt maturities out much further, so that Greece would need less on an ongoing basis from the Troika. Remember, in spite of all the talk about the bailout, huge chunks of money were going to be lent to Greece in the next few years solely for the purpose of paying back the ECB. This would be a big gain for Greece as it reduces debt, slashes annual interest costs, and extends maturities. It is merely a wash for the ECB on the P&L side, and actually seems reasonable.

Greece will soon have about €80 billion of Troika loans. These too need to be extended and have the already fairly low coupon, reduced further. In the fancy world of quasi government accounting this wouldn’t cause a loss, the citizens of the countries doing the lending already barely know what is going on, so any complaining about the extension and coupon reduction would be pretty short lived. This is the least critical element of the renegotiations, but would be done as a sign of good faith for everyone.

The austerity and spending programs need to be addressed as well. With the support of Hollande, they should be able to keep the total austerity “savings” the same, just push them well into the future. With the ECB on board, Greece has more flexibility in the near term. Programs that immediately hurt the economy short be cut/re-instated. Those cuts and be pushed out even further than they already are (remember, in spite of the outrage of austerity, relatively little has actually occurred). So keep the total over time the same, just shift how and where it occurs. This should be enough to keep Germany happy, and may even appease the bond markets. It gives the economy the best chance of recovering in the near term while working to ensure a sustainable future. Through in €10 – €20 billion of “shovel ready” EIB or EBRD infrastructure projects (possibly tied to unemployment benefits to reduce the cost) would get the “growth” bulls all excited. It’s probably needed, and although growth as a whole is hard to achieve, given the chaos of the past few years in Greece, there has to be some low hanging fruit that everyone can agree gives a good bank for the buck (or Euro).

With this plan, Greece and its people win. Bank shareholders are bigger losers than they already are, but that is marginal as none of the banks have big market caps anyways. The ECB “loses” but the reality is this just takes them back to being a non-profit which seems very reasonable, and if anything they could do even more. Germany could save some face as “austerity” would still exist, just the details would get shifted around. The IMF doesn’t give up much. These steps don’t solve the problems of Greece, but it should create a lot of breathing room. The new government would have achieved enough that leaving the Euro could be put off for a while and actually planned for.

In the end, who knows what will happen, but I would bet against a default in May, and the only way I would position for a potential default is with short dated puts struck about 5% out of the money.

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